As Fed nears rate hikes, policymakers plan for ‘brave new world’

The first hike may come as early as next month, but subsequent hikes are unlikely as monetary policy stares at limitations in containing overheating

US Federal Reserve chair Janet Yellen flanked by Stanley Fischer, vice-chairman of the Board of Governors of the Fed on her left, and Bill Dudley, the president of the New York Fed, ahead of Yellen's speech to central bankers from around the world at Jackson Lake Lodge in Grand Teton National Park, north of Jackson Hole, Wyoming.(AP)

Federal Reserve policymakers are signalling that they could raise US interest rates soon but they are already weighing new tools that they may need to fight the next recession.

A solid US labour market “has strengthened” the case for the first rate increase since last December, Fed chair Janet Yellen told a central banking conference here. Several of her colleagues said the increase could come as soon as next month if the economy does well.

Further rate hikes are expected to be few and far between as the US central bank tries to balance a desire to fuel growth against worries that it could overheat the economy.

But Fed officials at three-day conference that ended Saturday also said they need to consider new policy tools for use down the road, such as raising the inflation target or even Fed purchase of non-government-backed assets such as corporate debt.

Such ideas would test the limits of political feasibility and some would need congressional approval. The view within the Fed is that it could take effort to win over a public already sceptical of the unconventional policies that the Fed undertook during the last crisis.

“Central banking is in a brave new world,” Atlanta Fed President Dennis Lockhart said in an interview on the sidelines of the conference. “I suspect there are colleagues who are contemplating at least maybe a statically large balance sheet is just going to be a fact of life and be central to the toolkit.”

At the centre of the Fed’s discussions is its $4.5 trillion balance sheet, built up by bond-buying sprees to combat the 2007-09 recession but which has been criticised by many lawmakers.

While policymakers have maintained the Fed should eventually reduce its bond holdings, Lockhart said some officials were closer to accepting that they needed to learn to live with them.

Yellen, in her speech on Friday, said balance sheets would likely swell again in future recessions as the Fed snaps up assets to stimulate the economy.

The conference, attended by all but two of the Fed’s 17 policymakers as well as central bankers from around the world, also presented a menu of more exotic proposals. This included a Fed takeover of short-term debt markets and abolishing cash in order to charge negative interest rates.

Many of the more radical proposals, including one to abandon monetary policy altogether and focus on urging runaway deficit-spending, were seen as ivory tower musings.

Most policymakers, including Yellen, said it was likely the tools the Fed used to fight the last crisis, including rate cuts, bond purchases and jawboning on rate expectations, will be adequate.

Notably, her laundry list of possible tools did not include negative rates, an idea that has been nearly universally panned by Fed officials. She said the Fed is not actively considering additional policy tools but participants at the conference suggested the process is already well underway.